Indicate
by check mark whether the registrant (1) has filed all reports required to
be
filed by Section 13 or 15(d) of the Exchange Act during the preceding 12
months (or for such shorter period that the registrant was required to file
such
reports), and (2) has been subject to such filing requirements for the past
90
days.

Yes
[X]
No
[ ]

Indicate
by check mark whether the registrant is a large accelerated filer, and
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act,
(check one).

Large
Accelerated Filer [ ]

Accelerated
Filer [X]

Non-Accelerated
Filer [ ]

Indicate
by check mark whether the registrant is a shell company as defined in Rule
12b-2
of the Exchange Act. [ ] Yes [X] No

Indicate
the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: 66,738,486 shares of Common Stock
($.001 par value) as of May 1, 2007.

TELKONET,
INC.

FORM
10-Q for the Quarter Ended March 31, 2007

Index

Page

PART
I. FINANCIAL INFORMATION

Item
1. Financial Statements (Unaudited)

Condensed
Consolidated Balance Sheets:

March
31, 2007 and December 31, 2006

3

Condensed
Consolidated Statements of Operations:

4

Three
Months Ended March 31, 2007 and 2006

Condensed
Consolidated Statement of Stockholders’ Equity

Three
Months Ended March 31, 2007

5

Condensed
Consolidated Statements of Cash Flows:

Three
Months Ended March 31, 2007 and 2006

6

Notes
to Unaudited Condensed Consolidated Financial Information:

March
31, 2007

8

Item
2. Management’s Discussion and Analysis

26

Item
3. Quantitative and Qualitative Disclosures About Market
Risk

36

Item
4. Controls and Procedures

37

PART
II. OTHER INFORMATION

Item
1. Legal Proceedings

37

Item
1A. Risk Factors

37

Item
2. Unregistered Sales of Equity Securities and Use of
Proceeds

38

Item
3. Defaults Upon Senior Securities

38

Item
4. Submission of Matters to a Vote of Security Holders

38

Item
5. Other Information

38

Item
6. Exhibits

38

TELKONET,
INC.

CONDENSED
CONSOLIDATED BALANCE SHEETS

(Unaudited)

March
31, 2007

December
31, 2006

ASSETS

Current
Assets:

Cash
and cash equivalents

$

2,187,024

$

1,644,037

Accounts
Receivable: net of allowance for doubtful accounts of $207,000

Depreciation,
including depreciation of equipment under operating leases

321,146

215,537

Increase
/ decrease in:

Accounts
receivable

42,132

(320,083

)

Inventory

(130,631

)

157,727

Prepaid
expenses and deposits

(286,327

)

2,220

Customer
deposits and other current liability

9,683

(66,996

)

Accounts
payable and accrued expenses

(33,447

)

(155,536

)

Deferred
revenue

(37,848

)

97,963

Deferred
lease liability

-

245

Net
Cash (Used in) Operating Activities

(4,813,002

)

(3,138,964

)

Cash
Flows from Investing Activities:

Costs
of equipment under operating leases

(276,292

)

(316,716

)

Proceeds
from sale of equipment under operating lease

-

340,130

Payment
of note payable under subsidiary acquisition

(900,000

)

(1,017,822

)

Net
cash acquired from MST

-

59,384

Investment
in subsidiaries

(2,875,000

)

-

Investment
in affiliate

-

(44

)

Purchase
of property and equipment, net

(34,760

)

(134,704

)

Net
Cash (Used in) Investing Activities

(4,086,052

)

(1,069,772

)

Cash
Flows from Financing Activities:

Repayment
of convertible debentures

-

(1,250,000

)

Proceeds
from sale of common stock, net of costs

9,610,000

-

Proceeds
from exercise of stock options and warrants

31,000

974,503

Repayment
of subsidiary loans

(198,959

)

(409,675

)

Net
Cash Provided by (Used in) Financing Activities

9,442,041

(685,172

)

Net
Increase (Decrease) in Cash and Cash Equivalents

542,987

(4,893,908

)

Cash
and cash equivalents at the beginning of the
period

1,644,037

8,422,079

Cash
and cash equivalents at the end of the period

$

2,187,024

$

3,528,171

See
accompanying footnotes to the unaudited condensed consolidated financial
information

6

TELKONET,
INC.

CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

For
The Three Months

Ended
March 31,

2007

2006

Supplemental
Disclosures of Cash Flow Information

Cash
paid during the period for interest

$

-

$

622,530

Income
taxes paid

-

-

Non-cash
transactions:

Note
payable under subsidiary acquisition

-

900,000

Issuance
of shares for purchase of subsidiary

15,756,097

1,800,000

Employee
stock-based compensation

508,149

376,281

Warrants
issued in exchange for interest expense

131,009

-

Issuance
of stock options and warrants in exchange for services
rendered

-

277,344

Common
stock issued for services rendered

-

81,271

Acquisition
of subsidiary (Note B):

Assets
acquired

$

4,386,762

$

4,120,600

Goodwill
(including purchase price contingency)

15,797,894

6,477,767

Minority
Interest

-

(19,569

)

Liabilities
assumed

(1,303,559

)

(1,460,976

)

Common
stock issued

(15,756,097

)

(1,800,000

)

Notes
payable issued

-

(900,000

)

Purchase
price contingency

-

(5,400,000

)

Direct
acquisition costs

(250,000

)

(117,822

)

Cash
paid for acquisition

$

(2,875,000

)

$

(900,000

)

See
accompanying footnotes to the unaudited condensed consolidated financial
information

7

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
A - SUMMARY OF ACCOUNTING POLICIES

General

The
accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States of America for interim financial information and the instructions
to Form 10-Q. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements.

In
the
opinion of management, all adjustments (consisting of normal recurring accruals)
considered necessary for a fair presentation have been included. Accordingly,
the results from operations for the three-month period ended March 31, 2007,
are
not necessarily indicative of the results that may be expected for the year
ended December 31, 2007. The unaudited condensed consolidated financial
statements should be read in conjunction with the consolidated December 31,
2006
financial statements and footnotes thereto included in the Company's Form 10-K
for the year ended December 31, 2006.

Basis
of Presentation

Telkonet,
Inc. (the "Company"), formerly Comstock Coal Company, Inc., was formed on
November 3, 1999 under the laws of the state of Utah. The Company was a
“development stage enterprise” (as defined by Statement of Financial Accounting
Standards No. 7) until December 31, 2003. The Company is engaged in the business
of developing, producing and marketing proprietary equipment enabling the
transmission of voice and data over electric utility lines.

In
January 2006, following the acquisition of Microwave Satellite Technologies
(MST) (Note B), the Company began offering complete sales, installation,
and service of VSAT and business television networks, and became a
full-service national Internet Service Provider (ISP). The MST solution offers
a
complete “Quad-play” solution to subscribers of HDTV, VoIP telephony, NuVision
BroadbandInternet
access and wireless fidelity (“Wi-Fi”) access, to commercial multi-dwelling
units and hotels.

In
March
2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada.

In
March
2007, the Company acquired 100% of the outstanding membership units of
Ethostream, LLC, a network solutions integration company that offers
installation, sales and service to the hospitality industry. The Ethostream,
LLC
acquisition will enable Telkonet to provide installation and support for PLC
products and third party applications to customers across North America.

The
consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiaries, Telkonet Communications, Inc. and Ethostream, LLC
and
90% owned subsidiary Microwave Satellite Technologies (MST). Significant
intercompany transactions have been eliminated in consolidation.

Certain
reclassifications have been made to conform prior periods’ data to the current
presentation. These reclassifications had no effect on reported
losses.

8

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
A - SUMMARY OF ACCOUNTING POLICIES (continued)

Use
of
Estimates

The
preparation of consolidated financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts
of
assets and liabilities and disclosures of contingent assets and liabilities
at
the date of the condensed consolidated financial statements and the reported
amounts of revenue and expense during the reporting period. Actual results
could
differ from those estimates.

Concentrations
of Credit Risk

Financial
instruments and related items, which potentially subject the Company to
concentrations of credit risk, consist primarily of cash and cash equivalents.
The Company places its cash and temporary cash investments with credit quality
institutions. At times, such investments may be in excess of the FDIC insurance
limit. The
Company periodically reviews its trade receivables in determining its allowance
for doubtful accounts. The
allowance for doubtful accounts was $207,000 and $60,000 at March 31, 2007
and
December 31, 2006, respectively.

Revenue
Recognition

For
revenue from product sales, the Company recognizes revenue in accordance with
Staff Accounting Bulletin No. 104, Revenue
Recognition
(“SAB104”), which superceded Staff Accounting Bulletin No. 101,
Revenue
Recognition in Financial Statements
(“SAB101”). SAB 101 requires that four basic criteria must be met before revenue
can be recognized: (1) persuasive evidence of an arrangement exists; (2)
delivery has occurred; (3) the selling price is fixed and determinable; and
(4)
collectibility is reasonably assured. Determination of criteria (3) and (4)
are
based on management’s judgments regarding the fixed nature of the selling prices
of the products delivered and the collectibility of those amounts. Provisions
for discounts and rebates to customers, estimated returns and allowances, and
other adjustments are provided for in the same period the related sales are
recorded. The Company defers any revenue for which the product has not been
delivered or is subject to refund until such time that the Company and the
customer jointly determine that the product has been delivered or no refund
will
be required. SAB 104 incorporates Emerging Issues Task Force 00-21 (“EITF
00-21”), Multiple-Deliverable
Revenue Arrangements. EITF
00-21 addresses accounting for arrangements that may involve the delivery or
performance of multiple products, services and/or rights to use assets.

For
equipment under lease, revenue is recognized over the lease term for operating
lease and rental contracts. All of the Company’s leases are accounted for as
operating leases. At the inception of the lease, no lease revenue is recognized
and the leased equipment and installation costs are capitalized and appear
on
the balance sheet as “Equipment Under Operating Leases.” The capitalized cost of
this equipment is depreciated from two to three years, on a straight-line basis
down to the Company’s original estimate of the projected value of the equipment
at the end of the scheduled lease term. Monthly lease payments are recognized
as
rental income. For sales-type leases, we record the discounted present values
of
minimum rental payments under sales-type leases as sales.

MST
accounts for the revenue, costs and expense related to residential cable
services as the related services are performed in accordance with SFAS
No. 51, Financial Reporting by Cable Television Companies. Installation
revenue for residential cable services is recognized to the extent of direct
selling costs incurred. Direct selling costs have exceeded installation revenue
in all reported periods. Generally, credit risk is managed by disconnecting
services to customers who are delinquent.

Liquidity

As
shown
in the accompanying consolidated financial statements, the Company incurred
net
loss from continuing operating of $5,401,476 and $4,247,122 for the three months
ended March 31, 2007 and 2006, respectively. Net loss from continuing operations
included $131,009 and $461,754 of non-cash expense in connection with the
convertible debentures and $508,149 and $653,625 of non-cash compensation to
employees and non-employees in connection with stock options granted and vested
for the three months ended March 31, 2007 and 2006, respectively. The Company's
current assets, on a consolidated basis, exceeded its current liabilities by
$2,345,684as
of
March 31, 2007.

9

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
A - SUMMARY OF ACCOUNTING POLICIES (continued)

Guarantees
and Product Warranties

FASB
Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”),
requires that upon issuance of a guarantee, the guarantor must disclose and
recognize a liability for the fair value of the obligation it assumes under
that
guarantee.

The
Company’s guarantees were issued subject to the recognition and disclosure
requirements of FIN 45 as of March 31, 2007 and December 31, 2006. The Company
records a liability for potential warranty claims. The amount of the liability
is based on the trend in the historical ratio of claims to sales, the historical
length of time between the sale and resulting warranty claim, new product
introductions and other factors. The products sold are generally covered by
a
warranty for a period of one year. In the event the Company determines that
its
current or future product repair and replacement costs exceed its estimates,
an
adjustment to these reserves would be charged to earnings in the period such
determination is made. During the three months ended March 31, 2007 and the
year
ended December 31, 2006, the Company experienced approximately three percent
of
units returned under its product warranty policy. As of March 31, 2007 and
December 31, 2006, the Company recorded warranty liabilities in the amount
of
$57,120 and $47,300, respectively, using this experience factor.

New
Accounting Pronouncements

In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities.” SFAS 159 permits entities to choose
to measure many financial instruments, and certain other items, at fair value.
SFAS 159 applies to reporting periods beginning after November 15, 2007. The
adoption of SFAS 159 is not expected to have a material impact on the Company’s
financial condition or results of operations.

NOTE
B - ACQUISITION OF SUBSIDIARIES

Acquisition
of Microwave Satellite Technologies, Inc.

On
January 31, 2006, the Company acquired a 90% interest in Microwave Satellite
Technologies, Inc. (“MST”) from Frank Matarazzo, the sole stockholder of MST, in
exchange for $1.8 million in cash and 1.6 million unregistered shares of the
Company’s common stock for an aggregate purchase price of $9,000,000. The
purchase price of $9,000,000 was increased by $117,822 for direct costs related
to the acquisition. These direct costs included legal, accounting and other
professional fees. The

cash
portion of the purchase price was paid in two installments, $900,000 at closing
and $900,000 in February 2007. The stock portion is payable from shares held
in
escrow, 400,000 shares at closing and the remaining 1,200,000 “purchase price
contingency” shares issued based on the achievement of 3,300 “Triple Play”
subscribers over a three year period. In the year ended December 31, 2006,
the
Company issued 200,000 shares of the purchase price contingency valued at
$900,000 as an adjustment to Goodwill.

The
purchase price contingency shares are price protected for the benefit of the
former owner of MST. In the event the Company’s common stock price is below
$4.50 per share upon issuance of the shares from escrow, a pro rata adjustment
in the number of shares will be required to support the aggregate consideration
of $5.4 million. The price protection provision provides a cash benefit to
the
former owner of MST if the as-defined market price of the Company’s common stock
is less than $4.50 per share at the time of issuance from the escrow. The
issuance of additional shares or distribution of other consideration upon
resolution of the contingency based on the Company’s common stock prices will
not affect the cost of the acquisition. When the contingency is resolved or
settled, and additional consideration is distributable, the Company will record
the current fair value of the additional consideration and the amount previously
recorded for the common stock issued will be simultaneously reduced to the
lower
current value of the Company’s common stock.

MST
is a
communications technology company that offers complete sales, installation,
and
service of Very Small Aperture Terminal (VSAT) and business television networks,
and is a full-service national Internet Service Provider (ISP). Management
believes that the MST acquisition will enable Telkonet to provide a complete
“Quad-play” solution to subscribers of HDTV, VoIP telephony, NuVision
BroadbandInternet
access and wireless fidelity (“Wi-Fi”) access, to commercial multi-dwelling
units and hotels.

10

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
B - ACQUISITION OF SUBSIDIARIES (continued)

The
acquisition of MST was accounted for using the purchase method in accordance
with SFAS 141, “Business Combinations.” The value of the Company’s common stock
issued as a part of the acquisition was determined based on the average price
of
the Company's common stock for several days before and after the acquisition
of
MST. The results of operations for MST have been included in the Consolidated
Statements of Operations since the date of acquisition. The components of
the purchase price were as follows:

As
Reported

Including

Purchase
Price Contingency (*)

Common
stock

$

2,700,000

$

7,200,000

Cash
(including note payable)

1,800,000

1,800,000

Direct
acquisition costs

117,822

117,822

Purchase
price

4,617,822

9,117,822

Minority
interest

19,569

19,569

Total

$

4,637,391

$

9,137,391

In
accordance with Financial Accounting Standard (SFAS) No. 141, Business
Combinations, the total purchase price was allocated to the estimated fair
value
of assets acquired and liabilities assumed. The fair value of the assets
acquired was based on management’s best estimates. The purchase price was
allocated to the fair value of assets acquired and liabilities assumed as
follows:

As
Reported

Including

Purchase
Price Contingency (*)

Cash
and other current assets

$

346,548

$

346,548

Equipment
and other assets

1,310,125

1,310,125

Subscriber
lists

2,463,927

2,463,927

Goodwill
and other intangible assets

1,977,767

6,477,767

Subtotal

6,098,367

10,598,367

Current
liabilities

1,460,976

1,460,976

Total

$

4,637,391

$

9,137,391

(*)
At
the date of the acquisition, the effect of the “purchase price contingency”
shares valued at approximately $5.4 million had not been recorded in accordance
with FAS 141. In the second quarter of 2006, the Company issued 200,000 shares
of the purchase price contingency valued at $900,000 as an adjustment to
Goodwill. The remaining shares, when issued, will reflect an adjustment to
Goodwill and Other Intangibles.

Goodwill
and other intangible assets represent the excess of the purchase price over
the
fair value of the net tangible assets acquired. The Company engaged an
independent firm to assist in allocating the excess purchase price to the
intangible assets and goodwill as appropriate. In accordance with SFAS 142,
goodwill is not amortized and will be tested for impairment at least annually.
The subscriber list was independently valued at $2,463,927 with an estimated
useful life of eight years. This intangible was amortized using that life,
and
amortization from the date of the acquisition through March 31, 2007, was taken
as a charge against income in the consolidated statement of operations. In
accordance with SFAS 144, Accounting
for the Impairment or Disposal of Long-Lived Assets,
the
intangible asset subject to amortization was reviewed periodically for
impairment.
Goodwill of $1,977,768, excluding the remaining purchase price contingency,
represented the excess of the purchase price over the fair value of the net
tangible and intangible assets acquired.

11

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
B - ACQUISITION OF SUBSIDIARIES (continued)

At
December 31, 2006, the Company performed an impairment test on the goodwill
and
intangibles acquired, it was determined that there were no changes in the
carrying value of goodwill and intangibles acquired.

Acquisition
of Smart Systems International, Inc.

On
March
9, 2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada for cash and Company
common stock having an aggregate value of $6,875,000. The purchase price was
comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
stock. The Company is obligated to register the stock portion of the purchase
price on or before May 15, 2007 and 1,090,909 shares are being held in an escrow
account for a period of one year following the closing from which certain
potential indemnification obligations under the purchase agreement may be
satisfied. The aggregate number of shares held in escrow is subject to
adjustment upward or downward depending upon the trading price of the Company’s
common stock during the one year period following the closing date.

The
acquisition of SSI was accounted for using the purchase method in accordance
with SFAS 141, “Business Combinations.” The value of the Company’s common stock
issued as a part of the acquisition was determined based on the most recent
price of the Company's common stock on the day immediately preceding the
acquisition date. The results of operations for SSI have been included in the
Consolidated Statements of Operations since the date of acquisition. The
components of the purchase price were as follows:

As
Reported

Common
stock

$

6,000,000

Cash

875,000

Direct
acquisition costs

100,000

Total
Purchase Price

$

6,975,000

In
accordance with Financial Accounting Standard (SFAS) No. 141, Business
Combinations, the total purchase price was allocated to the estimated fair
value
of assets acquired and liabilities assumed. The fair value of the assets
acquired was based on management’s best estimates. The purchase price was
allocated to the fair value of assets acquired and liabilities assumed as
follows:.

Current
assets

$

1,229,867

Property,
plant and equipment

36,020

Other
assets

8,237

Goodwill

6,258,660

Total
assets acquired

7,532,784

Accounts
payable and accrued liabilities

(557,784

)

Total
liabilities assumed

(557,784

)

Net
assets acquired

$

6,975,000

Due
to
its recent date of acquisition, the purchase price allocation to Goodwill is
based upon preliminary data that is subject to adjustment and could change
significantly. In accordance with SFAS 142, goodwill is not amortized and will
be tested for impairment at least annually.

12

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
B - ACQUISITION OF SUBSIDIARIES (continued)

Acquisition
of Ethostream LLC

On
March
15, 2007, the Company acquired 100% of the outstanding membership units of
Ethostream, LLC, a network solutions integration company that offers
installation, sales and service to the hospitality industry. The Ethostream
acquisition will enable Telkonet to provide installation and support for PLC
products and third party applications to customers across North America. The
purchase price of $11,756,097 was comprised of $2.0 million in cash and
3,459,609 shares of the Company’s common stock. The entire stock portion of the
purchase price is being held in escrow to satisfy certain potential
indemnification obligations of the sellers under the purchase agreement. The
shares held in escrow are distributable over the three years following the
closing. If
during
the twelve months following the Closing, the Common Stock has a volume-weighted
average trading price of at least $4.50, as reported on the American Stock
Exchange, for twenty (20) consecutive trading days, the aggregate number of
shares of Common Stock issuable to the sellers shall be adjusted such that
the
number of shares of Common Stock issuable as the stock consideration shall
be
determined assuming a per share price equal to $4.50.

The
acquisition of Ethostream was accounted for using the purchase method in
accordance with SFAS 141, “Business Combinations.” The value of the Company’s
common stock issued as a part of the acquisition was determined based on the
most recent price of the Company's common stock prior to the acquisition date.
The results of operations for Ethostream have been included in the Consolidated
Statements of Operations since the date of acquisition. The components of
the purchase price were as follows:

As
Reported

Common
stock

$

9,756,097

Cash

2,000,000

Direct
acquisition costs

150,000

Total
Purchase Price

$

11,906,097

In
accordance with Financial Accounting Standard (SFAS) No. 141, Business
Combinations, the total purchase price was allocated to the estimated fair
value
of assets acquired and liabilities assumed. The fair value of the assets
acquired was based on management’s best estimates. The purchase price was
allocated to the fair value of assets acquired and liabilities assumed as
follows:.

Current
assets

$

1,029,615

Property,
plant and equipment

51,724

Other
assets

31,299

Subscriber
lists

2,000,000

Goodwill

9,539,234

Total
assets acquired

12,651,872

Accounts
payable and accrued liabilities

(745,775

)

Total
liabilities assumed

(745,775

)

Net
assets acquired

$

11,906,097

Goodwill
and other intangible assets represent the excess of the purchase price over
the
fair value of the net tangible assets acquired. Due to its recent date of
acquisition, the purchase price allocation to Intangibles and Goodwill is based
upon preliminary data that is subject to adjustment and could change
significantly pending the completion of an independent appraisal to accurately
evaluate this allocation. In accordance with SFAS 142, goodwill is not amortized
and will be tested for impairment at least annually. The subscriber list was
preliminarily valued and could also change significantly pending the completion
of an independent appraisal at $2,000,000 with an estimated useful life of
ten
years.

13

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
B - ACQUISITION OF SUBSIDIARIES (continued)

The
following unaudited condensed combined pro forma results of operations reflect
the pro forma combination of the Telkonet, MST, SSI and Ethostream, LLC
businesses as if the combination had occurred at the beginning of the periods
presented compared with the actual results of operations of Telkonet for the
same period. The unaudited pro forma condensed combined results of operations
do
not purport to represent what the companies’ combined results of operations
would have been if such transaction had occurred at the beginning of the periods
presented, and are not necessarily indicative of Telkonet’s future
results.

Three
Months Ended

March
31,

Proforma

2007

Proforma

2006

Product
revenue

$

1,386,652

$

2,407,050

Recurring
revenue

1,180,909

813,605

2,567,561

3,220,655

Net
(loss)

$

(5,668,394

)

$

(4,627,504

)

Basic
(loss) per share

$

(.08

)

$

(.08

)

Diluted
(loss) per share

$

(.08

)

$

(.07

)

NOTE
C - INVENTORIES

Inventories
are stated at the lower of cost or market determined by the first-in, first-out
(FIFO) method. Inventories primarily consist of Gateways, eXtenders, Couplers
and iBridges, which are the significant components of the Telkonet solution.
Additionally, inventories include raw materials and finished goods of Smart
Systems
International and finished goods of Ethostream, LLC as of the acquisition date
March 9, 2007 and March 15, 2007, respectively. Components of inventories as
of
March 31, 2007 and December 31, 2006 are as follows:

March
31, 2007

December
31, 2006

Raw
Materials

$

1,301,618

$

516,604

Finished
Goods

1,229,005

789,989

$

2,530,623

$

1,306,593

14

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
D - INTANGIBLE ASSETS AND GOODWILL

As
a result of MST acquisition at January 31, 2006 and the Ethostream acquisition
on March 15, 2007, the Company had intangibles totaling $4,463,927 at March
31,
2007 (Note B).

In
accordance with SFAS 142, Goodwill
and Other Intangible Assets (SFAF
No. 142), an impairment test will be performed on these assets at least
annually. The consolidated statement of operations for the three months ended
March 31, 2007 includes only charges for amortization of these
intangibles.

The
acquisition of MST resulted in the valuation by an independent appraiser of
MST’s subscriber lists as intangible assets. The MST subscriber list was
determined to have an eight-year life. This intangible was amortized using
that
life, and amortization from the date of the acquisition through March 31, 2007,
was taken as a charge against income in the consolidated statement of
operations. MST's goodwill of $1,977,767, excluding the purchase price
contingency, represented the excess of the purchase price over the fair value
of
the net tangible and intangible assets acquired.

The
acquisition of Ethostream resulted from preliminary estimates by management
and
is subject to adjustment upon the completion of the valuation by an independent
appraiser of Ethostream’s subscriber lists as intangible assets. The Ethostream
subscriber list was estimated to have a ten-year life. This intangible was
amortized using that life, and amortization from the date of the acquisition
through March 31, 2007, was taken as a charge against income in the consolidated
statement of operations. Ethostream's goodwill of $9,539,234 represented the
excess of the purchase price over the fair value of the net tangible and
intangible assets acquired.

Total
identifiable intangible assets acquired and their carrying value at December
31,
2006 are:

Gross

Carrying
Amount

Accumulated
Amortization

Net

Residual

Value

Weighted

Average

Amortization

Period

(Years)

Amortized
Identifiable tangible Assets:

Subscriber
lists

$

2,463,927

$

(282,325

)

$

2,181,602

$

-

8.0

Total
Amortized Identifiable Intangible Assets

2,463,927

(282,325

)

2,181,602

$

-

Unamortized
Identifiable Intangible Assets:

None

Total

$

2,463,927

$

(282,325

)

$

2,181,602

$

-

15

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
D - INTANGIBLE ASSETS AND GOODWILL (continued)

Total
identifiable intangible assets acquired and their carrying value at March 31,
2007 are:

Gross
Carrying Amount

Accumulated
Amortization

Net

Residual

Value

Weighted
Average Amortization Period (Years)

Amortized
Identifiable tangible Assets:

Subscriber
lists - MST

$

2,463,927

$

(359,323

)

$

2,104,604

$

-

8.0

Subscriber
lists - Ethostream

2,000,000

(8,333

)

1,991,667

-

10.0

Total
Amortized Identifiable Intangible Assets

4,463,927

(367,656

)

4,096,271

-

Unamortized
Identifiable Intangible Assets:

None

Total

$

4,463,927

$

(367,656

)

$

4,096,271

$

-

Total
amortization expense charged to operations for the three months ended March
31, 2007 was $85,331. Estimated amortization expense as of March 31, 2007 is
as
follows:

2007

$
380,993

2008

507,991

2009

507,991

2010

507,991

2011

507,991

2012
and after

1,683,314

Total

$
4,096,271

The
Company does not amortize goodwill. As a result of the acquisitions of MST,
Ethostream and SSI, the Company recorded goodwill in the aggregate amount of
$17,775,662 as of March 31, 2007. There were no changes in the carrying amount
of goodwill for the three months ended March 31,
2007.

Considerable
management judgment is necessary to estimate fair value. We enlisted the
assistance of an independent valuation consultant to determine the values of
our
intangible assets and goodwill as of the date of acquisition. Based on various
market factors and projections used by management, actual results could vary
significantly from managements' estimates.

NOTE
E - SENIOR CONVERTIBLE NOTES PAYABLE

During
the year ended December 31, 2005, the Company issued convertible
senior notes (the "Convertible Senior Notes") having an aggregate principal
value of $20 million to sophisticated investors in exchange for
$20,000,000, exclusive of $1,219,410 in placement costs and fees. The
Convertible Senior Notes accrue interest at 7.25% per annum and call for monthly
principal installments beginning March 1, 2006. The maturity date is 3 years
from the date of issuance of the notes. At any time or times, the Noteholders
shall be entitled to convert any portion of the outstanding and unpaid note
amount into fully paid and nonassessable shares
of
the Company’s common Shares at $5 per share. At any time at the option of the
Company, the principal payments may be paid either in cash or in common stock
at
the lower of $5 or 92.5% of the average recent market price. At any time after
six months should the stock trade at or above $8.75 for 20 of 30 consecutive
trading days, the Company can cause a mandatory redemption and conversion to
shares at $5 per share. At any time, the Company can pre-pay the notes with
cash
or common stock. Should the Company pre-pay the Notes other than by mandatory
conversion, the Company must issue additional warrants to the Noteholders
covering 65% of the amount pre-paid at a strike price of $5 per share. In
addition to standard financial covenants, the Company has agreed to maintain
a
letter of credit in favor of the Noteholders equal to $10 million. Once the
principal amount of the note declines below $15 million, the balance is reduced
by $.50 for every $1 amortized. In accordance with Emerging Issues Task Force
Issue 98-5, Accounting for Convertible Securities with a Beneficial Conversion
Features or Contingently Adjustable Conversion Ratios ("EITF 98-5"), the Company
recognized an imbedded beneficial conversion feature present in the notes.
The
Company allocated a portion of the proceeds equal to the intrinsic value of
that
feature to additional paid in capital. The Company recognized and measured
an
aggregate of $1,479,300 of the proceeds, which is equal to the intrinsic value
of the imbedded beneficial conversion feature, to additional paid in capital
and
a discount against the Notes issued during the year ended December 31, 2005.
The
debt discount attributed to the beneficial conversion feature is amortized
over
the Notes maturity period (three years) as interest expense.

16

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

In
connection with the placement of the Notes in October 2005, the Company has
also
agreed to issue to the Noteholders one million warrants to purchase company
common stock exercisable for five years at $5 per share. The Company recognized
the value attributable to the warrants in the amount of $2,919,300 to a
derivative liability due to the possibility of the Company having to make a
cash
settlement, including penalties, in the event the Company failed to register
the
shares underlying the warrants under the Securities Act of 1933, as amended,
within 90 days after the closing of the transaction. The Company accounted
for this warrant derivative in accordance with EITF 00-19 Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock. The warrants were included as a liability and valued at
fair market value until the Company met the criteria under EITF 00-19 for
permanent equity. A registration statement covering shares issuable to the
Noteholders upon conversion, amortization and/or redemption of the Convertible
Senior Notes and upon exercise of the warrants was filed with the Securities
and
Exchange Commission on Form S-3 on November 23, 2005 and was declared
effective on December 13, 2005. The warrant
derivative liability was valued at the issuance date of the Notes in the amount
of $2,919,300 and then revalued at $2,910,700 on December 13, 2005
upon effectiveness of the Form S-3. The Company charged $8,600 to Other
Income and the derivative warrant liability was reclassified to additional
paid
in capital at December 13, 2005. The Company valued the warrants in accordance
with EITF 00-27 using the Black-Scholes pricing model and the following
assumptions: contractual terms of 5 years, an average risk free interest rate
of
4.00%, a dividend yield of 0%, and volatility of 76%. The $2,919,300 of debt
discount attributed to the value of the warrants issued is amortized over the
Notes maturity period (three years) as interest expense.

For
the
period end March 31, 2006, the Company paid principal of $1,250,000 and interest
of $358,724 in cash. The Company amortized the debt discount to the beneficial
conversion feature and value of the attached warrants, and recorded non-cash
interest expense in the amount of $239,943 and $121,586, respectively.

The
Company has warrants due the Noteholders as a result of the anti-dilution impact
from a $10,000,000 private placement in February 2007 (Note I). The Company
has
accounted for the additional 76,230 warrants issued, valued at $131,009, as
interest expense during the period ended March 31, 2007. The Company valued
the
warrants using the Black-Scholes pricing model and the following assumptions:
contractual terms of 5 years, an average risk free interest rate of 4.75%,
a
dividend yield of 0%, and volatility of 70%.

Early
Extinguishment of Debt

On
August
14, 2006, the Company executed separate settlement agreements with the lenders
of its Convertible Senior Notes. Pursuant to the settlement agreements the
Company paid to the lenders on August 15, 2006 in the aggregate $9,910,392
plus
accrued but unpaid interest of $23,951 and certain premiums specified in the
Notes in satisfaction of the amounts then outstanding under the Notes. Of the
amount to be paid to the lenders under the Notes, $6,500,000 was paid in cash
through a drawdown on a letter of credit previously pledged as collateral for
the Company’s obligations under the Notes. The remaining note balance of
$1,428,314 and a Redemption Premium of $1,982,078, calculated as 25% of
remaining principal, was paid to the lenders in shares of Company’s common stock
valued at the lower of $5.00 per share and 92.5% of the arithmetic average
of
the weighted average price of the Company’s common stock on the American stock
exchange for the twenty trading days beginning on August 16, 2006. The Company
also issued 862,452 warrants to purchase shares of the Company’s common stock at
the exercise price of $2.58 per share (92.5% of the average trading price as
described above). The Company valued the warrants at $1,014,934 using the
Black-Scholes pricing model and the following assumptions: contractual terms
of
5 years, an average risk free interest rate of 5.00%, a dividend yield of 0%,
and volatility of 65%. The Company has accounted for the Redemption Premium
and
the additional warrants issued as non-cash early extinguishment of debt expense
during the year ended December 31, 2006. Registration statements covering the
shares underlying the warrants, were filed with the Securities and Exchange
Commission on Form S-3 on September 29, 2006 and October 13, 2006 and were
declared effective on October 16, 2006 and October 24, 2006, respectively.
As of
December 31, 2006, the Company included the warrant derivatives as equity since
the criteria under EITF 00-19 for permanent equity was achieved in a nominal
period of time subsequent to year end.

17

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
E - SENIOR CONVERTIBLE NOTES PAYABLE (Continued)

As
a
result of the execution of the settlement agreements and the payments required
thereby, the Company fully believes it repaid and satisfied all of its
obligations under the Notes. The Company also agreed to pay the expenses of
the
lenders incurred in connection with the negotiation and execution of the
settlement agreements. The settlement agreements were negotiated following
the
allegation by one of the lenders that the Company’s failure to meet the minimum
revenue test for the period ending June 30, 2006 as specified on the Notes
constituted an event of default under the Notes, which allegation the Company
disputed.

The
Settlement Agreement provides that the number of shares issued to the
Noteholders shall be adjusted based upon the arithmetic average of the weighted
average price of the Company’s common stock on the American Stock Exchange for
the twenty trading days immediately following the settlement date. The
Company has concluded that, based upon the weighted average of the Company's
common stock between August 16, 2006 and September 13, 2006, the Company is
entitled to a refund from the two Noteholders. One of the Noteholders has
informed the Company that it does not believe such a refund is required.
As a result, the Company has declined to deliver to the Noteholders certain
stock purchase warrants issued to them pursuant to the Settlement Agreement
pending resolution of this disagreement. The Noteholder has alleged that the
Company has failed to satisfy its obligations under the Settlement Agreement
by
failing to deliver the warrants. In addition, the Noteholder maintains that
the
Company has breached certain provisions of the Registration Rights Agreement
and, as a result of such breach, such Noteholder claims that it is entitled
to
receive liquidated damages from the Company.

NOTE
F - STOCK OPTIONS AND WARRANTS

Employee
Stock Options

The
following table summarizes the changes in options outstanding and the related
prices for the shares of the Company’s common stock issued to employees of the
Company under a non-qualified employee stock option plan.

The
weighted-average fair value of stock options granted to employees during the
period ended March 31, 2007 and 2006 and the weighted-average significant
assumptions used to determine those fair values, using a Black-Scholes option
pricing model are as follows:

2007

2006

Significant
assumptions (weighted-average):

Risk-free
interest rate at grant date

4.75%

5.0%

Expected
stock price volatility

70%

65%

Expected
dividend payout

-

-

Expected
option life-years

5.0

5.0

Total
stock-based compensation expense recognized in the consolidated statement of
earnings for the three months ended March 31, 2007 and 2006 was $354,186 and
$376,281, respectively, net of tax effect.

19

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
F - STOCK OPTIONS AND WARRANTS (Continued)

Non-Employee
Stock Options

The
following table summarizes the changes in options outstanding and the related
prices for the shares of the Company’s common stock issued to the Company
consultants. These options were granted in lieu of cash compensation for
services performed.

Options
Outstanding

Options
Exercisable

Exercise
Price

Number

Outstanding

Weighted
Average

Remaining
Contractual

Life
(Years)

Weighed
Average Exercise Price

Number

Exercisable

Weighted
Average Exercise Price

$
1.00

1,815,937

5.09

$
1.00

1,815,937

$
1.00

Transactions
involving options issued to non-employees are summarized as
follows:

Number
of Shares

Weighted
Average

Price
Per Share

Outstanding
at January 1, 2005

1,999,169

$1.07

Granted

15,000

3.45

Exercised

(172,395

)

2.07

Canceled
or expired

-

-

Outstanding
at December 31, 2005

1,841,774

$

1.00

Granted

-

-

Exercised

(25,837

)

1.00

Canceled
or expired

-

-

Outstanding
at December 31, 2006

1,815,937

$

1.00

Granted

-

-

Exercised

-

-

Canceled
or expired

-

-

Outstanding
at March 31, 2007

1,815,937

$

1.00

20

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
F - STOCK OPTIONS AND WARRANTS (Continued)

Warrants

The
following table summarizes the changes in warrants outstanding and the related
prices for the shares of the Company’s common stock issued to non-employees of
the Company. These warrants were granted in lieu of cash compensation for
services performed or financing expenses in connection with placement of
convertible debentures.

Warrants
Outstanding

Warrants
Exercisable

Exercise
Prices

Number

Outstanding

Weighted
Average

Remaining
Contractual

Life
(Years)

Weighed
Average Exercise Price

Number

Exercisable

Weighted
Average Exercise Price

$
2.59

862,452

4.37

$
2.59

862,452

$
2.59

$
4.17

4,236,739

4.69

$
4.17

4,236,739

$
4.17

$
4.70

2,211,628

3.96

$
4.70

2,211,628

$
4.70

7,310,819

4.43

$
4.14

7,310,819

$
4.14

Transactions
involving warrants are summarized as follows:

Number
of Shares

Weighted
Average Price Per Share

Outstanding
at January 1, 2005

575,900

$

1.12

Granted

1,040,000

4.85

Exercised

(371,900

)

1.00

Canceled
or expired

(14,000

)

1.00

Outstanding
at December 31, 2005

1,230,000

$

4.31

Granted

3,657,850

4.03

Exercised

(47,750

)

1.15

Canceled
or expired

(282,250

)

2.64

Outstanding
at December 31, 2006

4,557,850

$

4.20

Granted

2,752,969

4.18

Exercised

-

-

Canceled
or expired

-

-

Outstanding
at March 31, 2007

7,310,819

$

4.14

The
Company has warrants due the Noteholders as a result of the anti-dilution impact
from a $10,000,000 private placement in February 2007 (Note I). The Company
has
accounted for the additional 76,230 warrants issued, valued at $131,009, as
interest expense during the period ended March 31, 2007. The Company valued
the
warrants using the Black-Scholes pricing model and the following assumptions:
contractual terms of 5 years, an average risk-free interest rate of 4.75%,
a
dividend yield of 0%, and volatility of 70%.

The
anti-dilution impact of the private placements from August 2006 and February
2007 to the existing Noteholders, obligated the Company to re-price all of
the
affected purchase warrants outstanding from a price per share of $5.00, to
$4.87
as of December 31, 2006 and $4.70 as of March 31, 2007, respectively.

In
addition, the Company issued 2,600,000 warrants to
investors and 76,739 warrants to its placement agent in connection with the
private placement in February 2007 (Note I). The warrants issued to the
placement agent were valued at $139,112 using the Black-Scholes pricing model
and the following assumptions: contractual term of 5 years, an average risk-free
interest rate of 4.75 a dividend yield of 0% and volatility of
70%.

21

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
G - BUSINESS SEGMENTS

The
Company's reportable operating segments are strategic businesses differentiated
by the nature of their products, activities and customers and are described
as
follows:

Telkonet
(TKO) is engaged in the business of developing products for use in the powerline
communications (PLC) industry. PLC products use existing electrical wiring
in
commercial buildings and residences to carry high speed data communications
signals, including the internet.

Microwave
Satellite Technologies (MST) (Note B), offers complete sales, installation,
and service of VSAT and business television networks, and became a
full-service national Internet Service Provider (ISP). The MST solution offers
a
complete “Quad-play” solution to subscribers of HDTV, VoIP telephony, NuVision
Broadband Internet access and wireless fidelity (“Wi-Fi”) access, to
commercial multi-dwelling units and hotels.

The
measurement of losses and assets of the reportable segments is based on the
same
accounting principles applied in the consolidated financial statements.

Financial
data relating to reportable operating segments is as follows:

Three
Months ended March 31,

2007

2006

(In
thousands of U.S. $)

Revenues:

Telkonet

$

759

$

1,636

MST

487

308

Total
revenue

$

1,246

$

1,944

Three
Months ended March 31,

2007

2006

(In
thousands of U.S. $)

Gross
Profit

Telkonet

$

233

$

679

MST

(303

)

(31

)

Total
gross profit

$

(70

)

$

648

Loss
from Operations:

Telkonet

$

(4,147

)

$

(3,280

)

MST

(1,163

)

(369

)

Total
operating loss

$

(5,310

)

$

(3,649

)

22

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
G - BUSINESS SEGMENTS (Continued)

March
31,

2007

December
31

2006

(In
thousands of U.S. $)

Assets

Telkonet

$

24,210

$

4,137

MST

9,200

8,379

Total
assets

$

33,410

$

12,516

NOTE
H - MINORITY INTEREST IN SUBSIDIARY

Minority
interest in results of operations of consolidated subsidiaries represents the
minority shareholders' share of the income or loss of the consolidated
subsidiary MST. The minority interest in the consolidated balance sheet reflects
the original investment by these minority shareholder in the consolidated
subsidiaries, along with their proportional share of the earnings or losses
of
the subsidiaries.

On
January 31, 2006, the Company acquired a 90% interest in Microwave Satellite
Technologies, Inc. (“MST”) from Frank Matarazzo, the sole stockholder of MST in
exchange for $1.8 million in cash and 1.6 million unregistered shares of the
Company’s common stock for an aggregate purchase price of $9,000,000 (See Note
B). This transaction resulted in a minority interest of $19,569, which reflects
the original investment by the minority shareholders of MST. For the period
ended March 31, 2007, the minority shareholder's share of the loss of MST was
limited to $19,569. The minority interest in MST is a deficit and, in accordance
with Accounting Research Bulletin No. 51, subsidiary losses should not be
charged against the minority interest to the extent of reducing it to a negative
amount. As such, any losses will be charged against the Company's operations,
as
majority owner. However, if future earnings do materialize, the majority owner
should be credited to the extent of such losses previously absorbed in the
amount of $457,318.

NOTE
I - CAPITAL STOCK

The
Company has authorized 15,000,000 shares of preferred stock, par value $.001
per
share. As of March 31, 2007 and December 31, 2006, the Company had no preferred
stock issued and outstanding. The Company has authorized 100,000,000 shares
of
common stock, par value $.001 per share. As of March 31, 2007 and December
31,
2006, the Company had 66,710,183 and 56,992,301 shares of common stock issued
and outstanding, respectively.

During
the period ended March 31, 2007, the Company issued an aggregate of 31,000
shares of common stock for an aggregate purchase price of $31,000 to certain
employees upon exercise of employee stock options at approximately $1.00 per
share. (Note F).

On
March
9, 2007, the Company entered into an Asset Purchase Agreement (“Agreement”) with
Smart Systems International, a privately held company. Pursuant to the
Agreement, the Company issued 2,227,273 shares of Common Stock at approximately
$2.69 per share (Note B).

On
March
15, 2007, the Company entered into a Purchase Agreement (“Agreement”) with
Ethostream,LLC , a privately held company. Pursuant to the Agreement, the
Company issued 3,459,609 shares of Common Stock at approximately $2.82 per
share
(Note B).

During
the period ended March 31, 2007, the company issued 4,000,000 shares of Common
Stock valued at $2.50 per share for an aggregate purchase price of $10,000,000.
Total costs and fees include $390,000 of cash and 76,759 warrants paid to the
placement agent. The company also has issued to this investor warrants to
purchase 2.6 million shares of its common stock at an exercise price of $4.17
per share. A registration statement covering the shares underlying the warrants,
was filed with the Securities and Exchange Commission on Form S-3 on March
5, 2007 and was declared effective on March 20, 2007. As of March 31, 2007,
the
Company included the warrant derivatives as equity since the criteria under
EITF
00-19 for permanent equity was achieved in a nominal period during the quarter
ended March 31, 2007.

23

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
J - COMMITMENTS AND CONTINGENCIES

Employment
and Consulting Agreements

The
Company has employment agreements with certain of its key employees which
include non-disclosure and confidentiality provisions for protection of the
Company’s proprietary information.

The
Company has consulting agreements with outside contractors to provide marketing
and financial advisory services. The Agreements are generally for a term of
12
months from inception and renewable automatically from year to year unless
either the Company or Consultant terminates such engagement by written
notice.

The
Company entered into an exclusive financial advisor and consulting agreement
in
January 2007. The agreement provides a minimum consideration fee, not less
than
$250,000, in the event of an equity or financing transaction where the advisor
is engaged. The agreement may be terminated with sixty days notification by
either party.

Litigation

The
Company is subject to legal proceedings and claims which arise in the ordinary
course of its business. Although occasional adverse decisions or settlements
may
occur, the Company believes that the final disposition of such matters should
not have a material adverse effect on its financial position, results of
operations or liquidity.

Senior
Convertible Noteholder Claim

The
August 14, 2006 Settlement Agreement with the Senior Convertible Debenture
Noteholders provided that the number of shares issued to the Noteholders shall
be adjusted based upon the arithmetic average of the weighted average price
of
the Company’s common stock on the American Stock Exchange for the twenty trading
days immediately following the settlement date (Note E). The Company has
concluded that, based upon the weighted average of the Company's common stock
between August 16, 2006 and September 13, 2006, the Company is entitled to
a
refund from the two Noteholders. One of the Noteholders has informed the
Company that it does not believe such a refund is required. As a result,
the Company has declined to deliver to the Noteholders certain stock purchase
warrants issued to them pursuant to the Settlement Agreement pending resolution
of this disagreement. The Noteholder has alleged that the Company has failed
to
satisfy its obligations under the Settlement Agreement by failing to deliver
the
warrants. In addition, the Noteholder maintains that the Company has breached
certain provisions of the Registration Rights Agreement and, as a result of
such
breach, such Noteholder claims that it is entitled to receive liquidated damages
from the Company.

However,
in the Company’s opinion, the ultimate disposition of these matters will not
have a material adverse effect on the Company’s results of operations or
financial position.

24

TELKONET,
INC.

NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH
31, 2007

(UNAUDITED)

NOTE
J - COMMITMENTS AND CONTINGENCIES
(continued)

Purchase
Price Contingency

In
conjunction with the acquisition of MST on January 31, 2006, the purchase price
contingency shares are price protected for the benefit of the former owner
of
MST (Note B). In the event the Company’s common stock price is below $4.50 per
share upon issuance of the shares from escrow, a pro rata adjustment in the
number of shares will be required to support the aggregate consideration of
$5.4
million. The price protection provision provides a cash benefit to the former
owner of MST if the as-defined market price of the Company’s common stock is
less than $4.50 per share at the time of issuance from the escrow. The issuance
of additional shares or distribution of other consideration upon resolution
of
the contingency based on the Company’s common stock prices will not affect the
cost of the acquisition. When the contingency is resolved or settled, and
additional consideration is distributable, the Company will record the current
fair value of the additional consideration and the amount previously recorded
for the common stock issued will be simultaneously reduced to the lower current
value of the Company’s common stock.

On
March
9, 2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada for cash and Company
common stock having an aggregate value of $6,875,000. The purchase price was
comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
stock. The Company is obligated to register the stock portion of the purchase
price on or before May 15, 2007 and 1,090,909 shares are being held in an escrow
account for a period of one year following the closing from which certain
potential indemnification obligations under the purchase agreement may be
satisfied. The aggregate number of shares held in escrow is subject to
adjustment upward or downward depending upon the trading price of the Company’s
common stock during the one year period following the closing date.

On
March
15, 2007, the Company acquired 100% of the outstanding membership units of
Ethostream, LLC, a network solutions integration company that offers
installation, sales and service to the hospitality industry. The Ethostream
acquisition will enable Telkonet to provide installation and support for PLC
products and third party applications to customers across North America. The
purchase price of $11,756,097 was comprised of $2.0 million in cash and
3,459,609 shares of the Company’s common stock. The entire stock portion of the
purchase price is being held in escrow to satisfy certain potential
indemnification obligations of the sellers under the purchase agreement. The
shares held in escrow are distributable over the three years following the
closing. The aggregate number of shares issuable to the sellers is subject
to
downward adjustment in the event the Company’s common stock trades at or above a
price of $4.50 per share for twenty consecutive trading days during the one
year
period following the closing.

NOTE
K - NOTE RECEIVABLE

In
conjunction with the acquisition of Ethostream on March 15, 2007, the Company
maintains a net investment in certain sales-type lease notes receivable as
of
March 31, 2007 consisting of the following:

Total
Minimum Lease Payments to be Received

$

60,668

Less:
Unearned Interest Income

(5,132

)

Net
Investment in Sales-Type Lease Notes Receivable

55,536

Less:
Current Maturities

(37,562

)

Non-Current
Portion

$

17,974

Aggregate
future minimum lease payments to be received under the above leases are as
follows as of March 31, 2007:

2007

$

40,383

2008

11,690

2009

7,703

2010

912

$

60,688

NOTE L
- EMPLOYEE BENEFIT PLAN

The
Company maintains a Profit Sharing and Retirement Savings Plan for qualified
employees of its subsidiary MST as of the acquisition on January 31, 2006.
Telkonet’s expense for these benefits was $3,063 for the period ending March 31,
2007.

NOTE M
- BUSINESS CONCENTRATION

There
were no major customers with revenues representing more than 10% of total
revenues for the period ending March 31, 2007. Revenue from one major customers
approximated $683,451or 35% of sales for three-month period ended March 31,
2006.

Purchases
from three (3) major suppliers approximated $51,862 or 17% of purchases and
$48,496 or 33% of purchases for the period ended March 31, 2007 and 2006,
respectively. Total accounts payable of approximately $2,495 or 0.4% of total
accounts payable was due to these three suppliers as of March 31, 2007 and
approximately $19,255 or 5% of total accounts payable was due to these three
suppliers as of March 31, 2006.

25

Item
2. Management’s
Discussion and Analysis of Financial Condition and Results of
Operations

Business

Telkonet,
Inc., formed in 1999, develops and markets technology for the transmission
of
high-speed voice, video and data communications over the existing electrical
wiring within a building. Telkonet has made definitive inroads into the
Powerline communication (PLC) market and established the “leading” position for
in-building commercial communication solutions.

The
Company’s offices are located at 20374 Seneca Meadows Parkway, Germantown,
Maryland 20876. The reports that the Company files pursuant to the Securities
Exchange Act of 1934 can be found at the Company’s web site at
www.telkonet.com.

The
following discussion and analysis of the Company’s financial condition and
results of operations should be read in conjunction with the accompanying
financial statements and related notes thereto for the three-months ended March
31, 2007 and 2006, as well as the Company’s consolidated financial statements
and related notes thereto and management’s discussion and analysis of financial
condition and results of operations in the Company’s Form 10-K for the year
ended December 31, 2006 filed on March 16, 2007.

The
Company reports financial results for the following operating business
segments:

Telkonet
Segment (“Telkonet”)

Through
the revolutionary Telkonet iWire System™, Telkonet
utilizes proven PLC technology to deliver commercial high-speed Broadband access
from an IP “platform” that is easy to deploy, reliable and cost-effective by
leveraging a building’s existing electrical infrastructure. The building’s
existing electrical wiring becomes the backbone of the local area network,
which
converts virtually every electrical outlet into a high-speed data port, without
the costly installation of additional wiring or major disruption of business
activity. The segment’s net sales for the three months ended March 31, 2007 were
$759,363, representing 61% of the Company’s consolidated net sales.

On
March
9, 2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada for cash and Company
common stock having an aggregate value of $6,875,000. The purchase price was
comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
stock. The Company is obligated to register the stock portion of the purchase
price on or before May 15, 2007 and 1,090,909 shares are being held in an escrow
account for a period of one year following the closing from which certain
potential indemnification obligations under the purchase agreement may be
satisfied. The aggregate number of shares held in escrow is subject to
adjustment upward or downward depending upon the trading price of the Company’s
common stock during the one year period following the closing date.

On
March
15, 2007, the Company acquired 100% of the outstanding membership units of
Ethostream, LLC, a network solutions integration company that offers
installation, sales and service to the hospitality industry. The Ethostream,
LLC
acquisition will enable Telkonet to provide installation and support for PLC
products and third party applications to customers across North America. The
purchase price of $11,756,097 was comprised of $2.0 million in cash and
3,459,609 shares of the Company’s common stock. The entire stock portion of the
purchase price is being held in escrow to satisfy certain potential
indemnification obligations of the sellers under the purchase agreement. The
shares held in escrow are distributable over the three years following the
closing. If during the twelve months following the Closing, the Common Stock
has
a volume-weighted average trading price of at least $4.50, as reported on the
American Stock Exchange, for twenty (20) consecutive trading days, the aggregate
number of shares of Common Stock issuable to the sellers shall be adjusted
such
that the number of shares of Common Stock issuable as the stock consideration
shall be determined assuming a per share price equal to $4.50.

26

As
a
result of Telkonet's acquisition of Smart Systems International and
EthoStream, the Company can now provide hospitality owners with a
greater return on investment on technology investments. Hotel owners
can leverage the Telkonet iWire System™ platform to support wired and wireless
Internet access and, in the future, to support a networked energy management
system. With the synergy of Ethostream, LLC’s centralized remote monitoring and
management platform extending over HSIA, digital video surveillance and energy
management, hospitality owners will have a complete technology offering based
on
Telkonet’s core PLC system as the infrastructure backbone, demonstrating true
technology convergence.

MST
Segment (“MST”)

MST
is a
communications service provider offering quadruple-play (“Quad-Play”) services
to multi-tenant unit and multi-dwelling unit (“MDU”) residential, hospitality
and commercial properties. These Quad-Play services include video, voice,
high-speed internet and wireless fidelity (“Wi-Fi”) access. In addition, MST
currently offers or plans to offer a variety of next-generation
telecommunications solutions and services, including satellite installation,
video conferencing, surveillance/security and energy management, and other
complementary professional services. The segments’ net sales for the three
months ended March 31, 2007 were $486,906, representing 39% of the Company’s
consolidated net sales.

Forward
Looking Statements

This
report may contain “forward-looking statements,” which represent the Company’s
expectations or beliefs, including, but not limited to, statements concerning
industry performance and the Company’s results, operations, performance,
financial condition, plans, growth and strategies, which include, without
limitation, statements preceded or followed by or that include the words “may,”
“will,” “expect,” “anticipate,” “intend,” “could,” “estimate,” or “continue” or
the negative or other variations thereof or comparable terminology. Any
statements contained in this report or the information incorporated by reference
that are not statements of historical fact may be deemed to be forward-looking
statements within the meaning of Section 27(A) of the Securities Act of 1933
and
Section 21(F) of the Securities Exchange Act of 1934. For such statements,
the
Company claims the protection of the safe harbor for forward-looking statements
contained in the Private Securities Litigation Reform Act of 1995. These
statements by their nature involve substantial risks and uncertainties, some
of
which are beyond the Company’s control, and actual results may differ materially
depending on a variety of important factors, including those risk factors
discussed under “Trends, Risks and Uncertainties”, many of which are also beyond
the Company’s control. You should not place undue reliance on these
forward-looking statements, which speak only as of the date of this report.
The
Company does not undertake any obligation to update or release any revisions
to
these forward-looking statements to reflect events or circumstances after the
date of this report or to reflect the occurrence of unanticipated events, except
to the extent such updates and/or revisions are required by applicable
law.

Critical
Accounting Policies and Estimates

The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires us to make estimates
and assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. On an ongoing basis, we evaluate significant
estimates used in preparing our financial statements including those related
to
revenue recognition, guarantees and product warranties, stock based compensation
and business combinations. We base our estimates on historical experience,
underlying run rates and various other assumptions that we believe to be
reasonable, the results of which form the basis for making judgments about
the
carrying values of assets and liabilities. Actual results could differ from
these estimates. The following are critical judgments, assumptions, and
estimates used in the preparation of the consolidated financial
statements.

27

Revenue
Recognition

For
revenue from product sales, the Company recognizes revenue in accordance with
Staff Accounting Bulletin No. 104, Revenue
Recognition
(“SAB104”), which superceded Staff Accounting Bulletin No. 101,
Revenue
Recognition in Financial Statements
(“SAB101”). SAB 101 requires that four basic criteria must be met before revenue
can be recognized: (1) persuasive evidence of an arrangement exists; (2)
delivery has occurred; (3) the selling price is fixed and determinable; and
(4)
collectibility is reasonably assured. Determination of criteria (3) and (4)
are
based on management’s judgments regarding the fixed nature of the selling prices
of the products delivered and the collectibility of those amounts. Provisions
for discounts and rebates to customers, estimated returns and allowances, and
other adjustments are provided for in the same period the related sales are
recorded. The Company defers any revenue for which the product has not been
delivered or is subject to refund until such time that the Company and the
customer jointly determine that the product has been delivered or no refund
will
be required. SAB 104 incorporates Emerging Issues Task Force 00-21 (“EITF
00-21”), Multiple-Deliverable
Revenue Arrangements. EITF
00-21 addresses accounting for arrangements that may involve the delivery or
performance of multiple products, services and/or rights to use assets.

For
equipment under lease, revenue is recognized over the lease term for operating
lease and rental contracts. All of the Company’s leases are accounted for as
operating leases. At the inception of the lease, no lease revenue is recognized
and the leased equipment and installation costs are capitalized and appear
on
the balance sheet as “Equipment Under Operating Leases.” The capitalized cost of
this equipment is depreciated from two to three years, on a straight-line basis
down to the Company’s original estimate of the projected value of the equipment
at the end of the scheduled lease term. Monthly lease payments are recognized
as
rental income. For sales-type leases, we record the discounted present
values of minimum rental payments under sales-type leases as sales.

MST
accounts for the revenue, costs and expense related to residential cable
services as the related services are performed in accordance with SFAS
No. 51, Financial Reporting by Cable Television Companies. Installation
revenue for residential cable services is recognized to the extent of direct
selling costs incurred. Direct selling costs have exceeded installation revenue
in all reported periods. Generally, credit risk is managed by disconnecting
services to customers who are delinquent.

Guarantees
and Product Warranties

FASB
Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”),
requires that upon issuance of a guarantee, the guarantor must disclose and
recognize a liability for the fair value of the obligation it assumes under
that
guarantee.

The
Company’s guarantees were issued subject to the recognition and disclosure
requirements of FIN 45 as of March 31, 2007 and December 31, 2006. The Company
records a liability for potential warranty claims. The amount of the liability
is based on the trend in the historical ratio of claims to sales, the historical
length of time between the sale and resulting warranty claim, new product
introductions and other factors. The products sold are generally covered by
a
warranty for a period of one year. In the event the Company determines that
its
current or future product repair and replacement costs exceed its estimates,
an
adjustment to these reserves would be charged to earnings in the period such
determination is made. During the three months ended March 31, 2007 and the
year
ended December 31, 2006, the Company experienced approximately three percent
of
units returned under its product warranty policy. As of March 31, 2007 and
December 31, 2006, the Company recorded warranty liabilities in the amount of
$50,790 and $31,200, respectively, using this experience factor.

New
Accounting Pronouncements

In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities.” SFAS 159 permits entities to choose
to measure many financial instruments, and certain other items, at fair value.
SFAS 159 applies to reporting periods beginning after November 15, 2007. The
adoption of SFAS 159 is not expected to have a material impact on the Company’s
financial condition or results of operations.

28

Revenues

The
Company’s revenue consists of direct product sales and a recurring (lease) model
in the commercial, government and international markets of the Telkonet Segment
including a partial month activity for SSI and Ethostream, LLC from the date
of
acquisition through March 31, 2007. Additionally, the MST Segment consists
of
three months of revenue in 2007 and two months of revenue from date of
acquisition, January 31, 2006 through March 31, 2006 providing certain Quad-Play
services. The table below outlines product versus recurring (lease) revenues
for
comparable periods:

Three
months Ended

March
31, 2007

March
31, 2006

Variance

Product

$637,856

51%

$1,549,975

80%

$(912,119)

-59%

Recurring
(lease)

608,413

49%

393,937

20%

214,476

54%

Total

$1,246,269

100%

$1,943,912

100%

$(697,643)

-36%

Product
revenue

Product
revenue in the Telkonet Segment decreased by approximately $832,000 for the
three months ended March 31, 2007 compared to the prior year. The decrease
is
attributable the sale of certain rental contract agreements to HLC in the prior
year of approximately $683,000 as well as unanticipated delays in certain
Hospitality and Government direct installation initiatives in the three months
ended March 31, 2007. The Telkonet Segment product revenue principally arises
from the sale and installation of the Telkonet iWire SystemTM
directly
to commercial, government and international customers as well as through the
Value Added Reseller (VAR) purchase program. Additionally, the acquisitions
of
SSI and Ethostream in March 2007 provides the Telkonet Segement multiple
solutions of wired and wireless Internet access and energy management and from
date of acquisition through March 31, 2007 amounted to approximately $150,000
of
combined product revenue.

The
MST
Segment product revenue consists of equipment and installations and
ancillary services provided to customers.

In
the
three months ended March 31, 2006, the Company consummated a non-recourse sale
of certain rental contract agreements and the related capitalized equipment
which were accounted for as operating leases with Hospitality Leasing
Corporation. The remaining rental income payments of the contracts were valued
at approximately $1,168,000 including the customer support component of
approximately $357,000 which the Company will retain and continue to receive
monthly customer support payments over the remaining average unexpired lease
term of 37 months. In the period ending March 31, 2006, the Company recognized
revenue of approximately $683,000 for the sale, calculated based on the present
value of total unpaid rental payments, and expensed the associated capitalized
equipment cost, net of depreciation, of approximately $340,000 and expensed
associated taxes of approximately $64,000.

Recurring
(lease) Revenue

The
recurring revenue for the MST segment subscriber base amounted to approximately
$427,000 and $168,000 for the three and two months ended March 31, 2007 and
2006, respectively. The MST Segment subscriber portfolio includes approximately
20 MDU properties with bulk service agreements and/or access licenses to service
the individual subscribers in metropolitan New York. The Telkonet Segment
recurring (lease) revenue decreased by approximately $45,000 in the three months
ended March 31, 2007 compared to the prior year primarily due to the sale of
rental contracts to Hospitality Leasing Corporation (HLC) in 2006. As a result
of the acquisition of Ethostream, the Telkonet Segment supports approximately
150,000 HSIA rooms and anticipates continued leadership in the HSIA industry.

29

Cost
of Sales

Three
months Ended

March
31, 2007

March
31, 2006

Variance

Product

$429,468

67%

$983,651

63%

$(554,183)

-56%

Recurring
(lease)

886,993

146%

311,919

79%

575,074

184%

Total

$1,316,461

106%

$1,295,570

67%

$20,891

2%

Product
Costs

The
Telkonet Segment product cost for the Telkonet iWire SystemTM
product
suite primarily includes equipment costs and installation labor. During the
three months ended March 31, 2007, product costs decreased by approximately
$422,000 for the Telkonet Segment, including the non-recourse sale of rental
contract agreements in the period ended March 31, 2006 which amounted to
approximately $347,000 of previously capitalized costs.

The
MST
segment product costs primarily consist of equipment and installation labor
for
installation and ancillary services provided to customers.

Recurring
(lease) Costs

MST
segment recurring costs primarily represent customer support, programming and
amortization of the capitalized costs to support the subscriber revenue.
Although MST's programming fees are a significant portion of the cost, MST
continues to pursue competitive agreements and volume discounts in conjunction
with the anticipated growth of the subscriber base. The customer support costs
for the three months ended March 31, 2007 include build-out of the support
services necessary to develop and support the build-out of the “Quad-Play”
subscriber base in metropolitan New York. The capitalized costs are amortized
over the lease term and include equipment and installation labor. The Telkonet
Segment recurring costs decreased for the three months ended March 31, 2007
compared to the prior year period due to the sale of certain rental
contracts.

Gross
Profit

Three
months Ended

March
31, 2007

March
31, 2006

Variance

Product

$208,388

33%

$566,324

37%

$(357,936)

-63%

Recurring
(lease)

(278,580)

-46%

82,018

21%

(360,598)

-440%

Total

$(70,192)

-6%

$648,342

33%

$(718,534)

-111

Product
Gross Profit

The
gross
profit for the three months ended March 31, 2007 decreased compared to the
prior
year period which is attributable to the decrease in product revenue compared
to
the prior year as well as the gross profit attributable to the sale of the
HLC
contracts in the prior year.

Recurring
(lease) Gross Profit

Telkonet
Segment gross profit associated with recurring (lease) revenue decreased as
a
result of the sale of rental contracts to HLC resulting in a decrease in
recurring (lease) revenue which offset by increased customer support services.
As MST develops the infrastructure and continues to build-out the “Quad-Play”
subscriber base, the gross margins decreased approximately $324,000 for the
three months ended March 31, 2007 compared to the prior year, primarily due
to
programming costs and the support infrastructure.

30

Operating
Expenses

Three
months Ended

March
31, 2007

March
31, 2006

Variance

Total

$5,240,047

$4,297,464

$942,583

22%

Overall
expenses increased for the three months ended March 31, 2007 over the comparable
period in 2006 by $942,583 or 22%. The principal reasons for this increase
were
operating costs related to the build-out of the “Quad Play” subscriber
infrastructure through the MST segment. Additionally, the Telkonet operating
expenses increased for the three months ended March 31, 2007 compared to the
prior year due to administrative costs, a loss on the sub-lease of the Crystal
City, VA office space and an increase in sales and marketing expenses for the
period ending March 31, 2007.

Product
Research and Development

Three
months Ended

March
31, 2007

March
31, 2006

Variance

Total

$474,603

$432,569

$42,034

10%

Telkonet’s
research and development costs related to both present and future products
are
expensed in the period incurred. Total expenses for the three months ended
March
31, 2007 increased over the comparable prior year by $42,034 or 10%. This
increase was primarily related to costs associated the development of the next
generation product suite and the integration of new applications to the Telkonet
iWire System.

Selling,
General and Administrative

Three
months Ended

March
31, 2007

March
31, 2006

Variance

Total

$4,260,111

$3,092,043

$1,168,068

38%

Selling,
general and administrative expenses increased for the three months ended March
31, 2007 over the comparable prior year by $1,168,068 or 38%. This increase
is
attributed to the administrative expenses such as payroll costs, advertising,
trade shows, facility costs and professional fees.

Backlog

In
conjunction with the acquisition of Ethostream, LLC on March 15, 2007, the
Telkonet Segment maintains contracts and monthly services for more than 1900
hotels which are expected to generate approximately $2,400,000 annual recurring
support and internet advertising revenue. Additionally, Telkonet has been
contracted to deploy the Telkonet iWire SystemTM
at 50
properties for a major resort company which deployment represents revenue of
approximately $1,100,000 over a 3 year term.

In
conjunction with the acquisition of Smart Systems International on March 9,
2007, Telkonet assumed certain purchase orders relating to a major utilities
energy management initiative provided through the two selected providers. The
current order backlog amounts to approximately $500,000 and the estimated
remaining program value amounts to $3,000,000 for products and services to
be
provided through 2008.

31

The
MST
subscriber portfolio includes approximately 20 MDU properties with bulk service
agreements and/or access licenses to service the individual subscribers in
metropolitan New York. The remaining terms of the access agreements provide
MST
access rights from 7 to 15 years with the final agreement expiring in 2016
and
the revenues to be recognized under non-cancelable bulk agreements provide
a
minimum of $1,800,000 in revenue through 2013.

Liquidity
and Capital Resources

Working
Capital

Our
working capital increased by $2,876,315 during the three months ended March
31,
2007 from a working capital deficit of $(530,631) at December 31, 2006 to a
working capital of $2,345,684 at March 31, 2007. The increase in working capital
for the three-months ended March 31, 2007, is due to a combination of factors,
of which the significant factors are set out below:

·

Cash
had an increase from working capital by $542,987 for the period ended
March 31, 2007. The most significant uses and proceeds of cash are
as
follows:

o

Approximately
$4,800,000 of cash consumed directly in operating
activities

o

A
cash payment of $900,000 representing the second installment of the
cash
portion of the purchase price for the acquisition of
MST

o

The
cash payment in the acquisition of Ethostream amounted to approximately
$2,000,000, and as part of the acquisition the debt payoff amounted
to
approximately $200,000—see discussion of acquisition
below;

o

The
cash payments in the acquisition of SSI amounted to approximately
$875,000—see discussion of acquisition
below;

o

A
private placement from the sale of 4,000,000 shares of common stock
at
$2.50 per share provided proceeds of
$9,610,000.

Of
the
total $6,903,799 current assets as of March 31, 2007, cash represented
$2,187,024. Of the total $3,766,079 current assets as of December 31, 2006,
cash
represented $1,644,037.

Convertible
Senior Notes

In
October 2005, the Company completed an offering of convertible senior notes
(the
“Notes”) in the aggregate principal amount of $20 million. The capital raised in
the Note offering was used for general working capital purposes. The Notes
bore
interest at a rate of 7.25%, payable in cash, and called for monthly principal
installments beginning March 1, 2006. The maturity date was 3 years from the
date of issuance of the Notes. The Noteholders were entitled, at any time,
to
convert any portion of the outstanding and unpaid Conversion Amount into shares
of Company common stock. At the option of the Company, the principal payments
could be paid either in cash or in common stock. Upon conversion into common
stock, the value of the stock was determined by the lower of $5 or 92.5% of
the
average recent market price. The Company also issued one million warrants to
the
Noteholders exercisable for five years at $5 per share. At any time after six
months, should the stock trade at or above $8.75 for 20 of 30 consecutive
trading days, the Company could cause a mandatory redemption and conversion
to
shares at $5 per share. At any time, the Company was entitled to pre-pay the
notes with cash or common stock. If the Company elected to use common stock
to
pre-pay the Notes, the price of the common stock would be deemed to be the
lower
of $5 or 92.5% of the average recent market price. If the Company prepaid the
Notes other than by mandatory conversion, the Company was obligated to issue
additional warrants to the Noteholders covering 65% of the amount pre-paid
at a
strike price of $5 per share. In addition to standard financial covenants,
the
Company agreed to maintain a letter of credit in favor of the Noteholders equal
to $10 million. Once the principal amount outstanding on the notes declined
below $15 million, the balance on the letter of credit was reduced by $.50
for
every $1 amortized.

32

These
notes were repaid on August 14, 2006 as discussed in greater detail below under
“Early Extinguishment of Debt.”

Principal
Payments of Debt

For
the
period end March 31, 2006, the Company paid principal of $1,250,000 and interest
of $358,724 in cash. The Company amortized the debt discount to the beneficial
conversion feature and value of the attached warrants, and recorded non-cash
interest expense in the amount of $239,943 and $121,586, respectively.

Early
Extinguishment of Debt

On
August
14, 2006, the Company executed separate settlement agreements with the lenders
of its Convertible Senior Notes. Pursuant to the settlement agreements the
Company paid to the lenders in the aggregate $9,910,392 plus accrued but unpaid
interest of $23,951 and certain premiums specified in the Notes in satisfaction
of the amounts then outstanding under the Notes. Of the amount to be paid to
the
lenders under the Notes, $6,500,000 was paid in cash through a drawdown on
a
letter of credit previously pledged as collateral for the Company’s obligations
under the Notes. The remaining note balance of $1,428,314 and a Redemption
Premium of $1,982,078, calculated as 25% of remaining principal, was paid to
the
lenders in shares of Company’s common stock valued at the lower of $5.00 per
share and 92.5% of the arithmetic average of the weighted average price of
the
Company’s common stock on the American Stock Exchange for the twenty trading
days beginning on August 16, 2006. The Company also issued 862,452 warrants
to
purchase shares of the Company’s common stock at the exercise price of the lower
of $2.58 per share and 92.5% of the average trading price as described above.
The Company has accounted for the Redemption Premium and the additional warrants
issued as non-cash early extinguishment of debt expense during the year ended
December 31, 2006.

As
a
result of the execution of the settlement agreements and the payments required
thereby, the Company fully repaid and believes it satisfied all of its
obligations under the Notes. The Company also agreed to pay the expenses of
the
lenders incurred in connection with the negotiation and execution of the
settlement agreements. The settlement agreements were negotiated following
the
allegation by one of the lenders that the Company’s failure to meet the minimum
revenue test for the period ending June 30, 2006 as specified on the Notes
may
have constituted an event of default under the Notes, which allegation the
Company disputed.

In
conjunction with the settlement agreement, the Company recorded $4,626,679
of
loss from early extinguishment of debt, which consists of $1,982,078 redemption
premium paid with the Company’s common stock, $1,014,934 of additional warrants
issued to the lenders, write-off of the remaining unamortized debt discount
attributed to the beneficial conversion feature and the value of the attached
warrants in the amount of $430,040 and $845,143, respectively, and write-off
the
remaining unamortized financing costs of $354,484.

The
settlement agreements provide that the number of shares issued to the
noteholders shall be adjusted based upon the arithmetic average of the weighted
average price of the Company’s common stock on the American Stock Exchange for
the twenty trading days immediately following the settlement date. The
Company has concluded that, based upon the weighted average of the Company's
common stock between August 16, 2006 and September 13, 2006, the Company is
entitled to a refund from the two noteholders. One of the noteholders has
informed the Company that it does not believe such a refund is required.
As a result, the Company has declined to deliver to the noteholders certain
stock purchase warrants issued to them pursuant to the settlement agreements
pending resolution of this disagreement. One of the noteholders has alleged
that
the Company has failed to satisfy its obligations under the settlement agreement
by failing to deliver the warrants. In addition, the noteholder maintains that
the Company has breached certain provisions of the registration rights agreement
and, as a result of such breach, such noteholder claims that it is entitled
to
receive liquidated damages from the Company. As of May 1, 2007, no legal claim
has been filed by the noteholder.

33

Acquisition
of Microwave Satellite Technologies, Inc.

On
January 31, 2006, the Company acquired a 90% interest in MST from Frank
Matarazzo, the sole stockholder of MST in exchange for $1.8 million in cash
and
1.6 million unregistered shares of the Company’s common stock for an aggregate
purchase price of $9,000,000. The cash portion of the purchase price was paid
in
two installments, $900,000 at closing and $900,000 in February 2007. The stock
portion is payable from shares which will be held in escrow, 400,000 shares
of
which were paid at closing and the remaining 1,200,000 shares of which shall
be
issued based on the achievement of 3,300 “Triple Play” subscribers over a three
year period. In the period ended December 31, 2006, the Company issued 200,000
shares of the purchase price contingency valued at $900,000 as an adjustment
to
goodwill. In the event the Company’s common stock price is below $4.50 per share
upon issuance of the shares from escrow, a pro rata adjustment in the number
of
shares will be required to support the aggregate consideration of $5.4 million.
As of March 31, 2007, the Company’s common stock price was below $4.50. To the
extent that the market price of Company’s common stock is below $4.50 per share
upon issuance of the shares from escrow, the number of shares issuable on
conversion is ratably increased, which could result in further dilution of
the
Company’s stockholders.

Acquisition
of Smart Systems International (SSI)

On
March
9, 2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada for cash and Company
common stock having an aggregate value of $6,875,000. The purchase price was
comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
stock. The Company is obligated to register the stock portion of the purchase
price on or before May 15, 2007 and 1,090,909 shares are being held in an escrow
account for a period of one year following the closing from which certain
potential indemnification obligations under the purchase agreement may be
satisfied. The aggregate number of shares held in escrow is subject to
adjustment upward or downward depending upon the trading price of the Company’s
common stock during the one year period following the closing date.

Acquisition
of Ethostream, LLC

On
March
15, 2007, the Company acquired 100% of the outstanding membership units of
Ethostream, LLC, a network solutions integration company that offers
installation, sales and service to the hospitality industry. The purchase price
of $11,756,097 was comprised of $2.0 million in cash and 3,459,609 shares of
the
Company’s common stock. The entire stock portion of the purchase price is being
held in escrow to satisfy certain potential indemnification obligations of
the
sellers under the purchase agreement. The shares held in escrow are
distributable over the three years following the closing. The aggregate number
of shares issuable to the sellers is subject to downward adjustment in the
event
the Company’s common stock trades at or above a price of $4.50 per share for
twenty consecutive trading days during the one year period following the
closing.

Proceeds
from the issuance of common stock

During
the three months ended March 31, 2007, the Company received $31,000 from the
exercise of employee stock options.

During
the three months ended March 31, 2007, the Company issued 4,000,000 shares
of
Common Stock valued at $2.50 per share for an aggregate purchase price of
$9,610,000, net of placement fees. The Company also issued to this investor
warrants to purchase 2.6 million shares of its common stock at an exercise
price
of $4.17 per share in this private placement transaction.

Cashflow
analysis

Cash
utilized in operating activities was $4,813,002 during the three months ended
March 31, 2007 compared to $3,138,964 the previous comparable period.
The
primary use of cash during the three months ended March 31, 2007 was for
operating activities.

34

The
Company utilized cash for investing activities of $4,086,052 and $1,069,772
during the three months ended March 31, 2007 and 2006, respectively.
These
expenditures were primarily the result of the payment of cash portion of the
MST
purchase price payable in February 2007 and the acquisition of SSI and
Ethostream in March 2007 of $875,000 and $2,000,000, respectively. Additionally,
cost of equipment under operating leases amounted to $276,292 and $316,716
for
the three months ended March 31, 2007 and 2006, respectively, offset by proceeds
from sale of certain equipment under operating lease of $340,130 for the three
months ended March 31, 2006. Furthermore, purchases of property and equipment
amounted to $34,760 and $134,704 for the three months ended March 31, 2007
and
2006, respectively.

The
Company was provided and utilized cash in financing activities of $9,442,041
and
$685,172 during the three months ended March 31, 2007 and 2006, respectively.
The financing activities represent proceeds from the sale of 4.0 million shares
of common stock at $2.50 per share for an aggregate purchase price of
$9,610,000, net of placement fees, during the three months ended March 31,
2007.
Additionally, the financing activities represent proceeds from the exercise
of
stock options and warrants of $31,000 and $974,530 during the three months
ended
March 31, 2007 and 2006, respectively. In 2006, the proceeds of the financing
activities were offset by repayment of senior convertible debt principal of
$1,250,000 and repayment of debt of $409,675 and, in 2007, repayment of the
subsidiary debt of $198,959.

The
Company believes it has sufficient access to capital to meet its working capital
requirements through the remainder of 2007 in available cash and in cash
generated from operations. Additional financing may be required in order to
meet
growth opportunities in financing and/or investing activities. If additional
capital is required and the Company is not successful in generating sufficient
liquidity from operations or in raising sufficient capital resources on terms
acceptable to the Company, this could have a material adverse effect on the
Company’s business, results of operations, liquidity and financial
condition.

If
additional capital is required and the Company is not successful in generating
sufficient liquidity from operations or in raising sufficient capital resources
on terms acceptable to the Company, this could have a material adverse effect
on
the Company’s business, results of operations, liquidity and financial
condition.

Inflation

We
do not
believe that inflation has had a material effect on our business, financial
condition or results of operations. If our costs were to become subject to
significant inflationary pressures, we may not be able to fully offset such
higher costs through price increases. Our inability or failure to do so could
adversely affect our business, financial condition and results of
operations.

Off
Balance Sheet Arrangements

None.

Acquisition
or Disposition of Property and Equipment

During
the three months ended March 31, 2007, fixed assets and costs under operating
leases increased $311,052 primarily for additions to the MST Segment equipment
purchases for the MST “Quad-Play” build-out. The remainder related to computer
equipment and peripherals used in day-to-day operations. The Company anticipates
significant expenditures in the MST Segment to continue the build-out the
head-end equipment, IPTV and other related projects. The Telkonet segment does
not anticipate the sale or purchase of any significant property, plant or
equipment during the next twelve months, other than the purchase of computer
equipment and peripherals to be used in the Company’s day-to-day operations.

In
April
2005, the Company entered into a three-year lease agreement for 6,742 square
feet of commercial office space in Crystal City, Virginia. Pursuant to this
lease, the Company agreed to assume a portion of the build-out cost for this
facility. In February 2007, the Company agreed to sub-lease the Crystal City,
Virginia office through the remaining term of the contract resulting in a loss
of approximately $192,000.

35

MST
presently leases 12,600 square feet of commercial office space in Hawthorne,
New
Jersey for its office and warehouse spaces. This lease will expire in April
2010.

Following
the acquisitions of Smart Systems International and Ethostream, the Company
assumed leases on 9,000 square feet of office space in Las Vegas, NV for
the Smart Systems International office and warehouse space on a month to month
basis and 4,100 square feet of office space in Milwaukee, WI for Ethostream.
The
Ethostream lease expires in May 2011.

Number
of Employees

As
of May
1, 2007, the Company had 182 full time employees.

Disclosure
of Contractual Obligations

Payment
Due by Period

Contractual
obligations

Total

Less
than 1 year

1-3
years

3-5
years

More
than 5 years

Long-Term
Debt Obligations

-

-

-

-

-

Capital
Lease Obligations

$

17,921

6,078

11,843

-

-

Operating
Lease Obligations

$

1,758,147

493,068

693,551

296,306

275,222

Purchase
Obligations

-

Other
Long-Term Liabilities Reflected on the Registrant’s Balance Sheet Under
GAAP

-

Total

$

1,776,068

499,146

705,394

296,306

275,222

Item
3.Quantitative
and Qualitative Disclosures About Market Risk.

Short
Term Investments

We
held
no marketable securities as of March 31, 2007. Our excess cash is held in money
market accounts in a bank and brokerage firms both of which are nationally
ranked top tier firms with an average return of approximately 400 basis points.
Due to the conservative nature of our investment portfolio, an increase or
decrease of 100 basis points in interest rates would not have a material effect
on our results of operations or the fair value of our portfolio.

Investments
in Privately Held Companies

We
have
invested in privately held companies, which are in the startup or development
stages. These investments are inherently risky because the markets for the
technologies or products these companies are developing are typically in the
early stages and may never materialize. As a result, we could lose our entire
initial investment in these companies. In addition, we could also be required
to
hold our investment indefinitely, since there is presently no public market
in
the securities of these companies and none is expected to develop. These
investments are carried at cost, which as of May 1, 2007 was $131,044 and $8,000
in BPL Global and Amperion, respectively, and at March 31, 2007, are recorded
in
other assets in the Consolidated Balance Sheets.

36

Item
4. Controls
and Procedures.

As
of
March 31, 2007, the Company performed an evaluation, under the supervision
and
with the participation of management, including the Chief Executive Officer
and
Vice President Finance (Principal Accounting Officer), of the effectiveness
of
the design and operation of its disclosure controls and procedures as defined
in
Rules 13a - 15(e) or 15d - 15(e) promulgated under the Securities Exchange
Act
of 1934, as amended (the “Exchange Act”). Based upon that evaluation, the Chief
Executive Officer and Vice President Finance concluded that the Company’s
disclosure controls and procedures are effective in timely alerting them to
material information required to be included in the Company’s periodic filings
with the U.S. Securities and Exchange Commission. During the three months ended
March 31, 2007, there was no change in the Company’s internal control over
financial reporting (as such term is defined in Rule 13a-15(f) under the
Exchange Act) that has materially affected, or is reasonably likely to
materially affect, the Company’s internal control over financial
reporting.

PART
II. OTHER INFORMATION

Item
1. Legal
Proceedings.

None.

Item
1A. Risk Factors.

The
Company’s results of operations, financial condition and cash flows can be
adversely affected by various risks. These risks include, but are not limited
to, the principal factors listed below and the other matters set forth in this
quarterly report on Form 10-Q. You should carefully consider all of these
risks.